Taking Risks: Lessons from a Politician

In my spare time, I like to read about current affairs. I have an interest in Brexit and its resulting economic impact which I covered well before the referendum here.  My current reading list is here.  My interests include the Middle East, and it was with that in mind that I picked up a book by the late Shimon Peres, former President of the State of Israel, which he completed just before he passed away in September 2016.  He also served as Finance Minister when hyperinflation was one of the main features of the economy and initiated a bold programme that tamed inflation successfully.

I found the title of the book, No Room for Small Dreams, a bit puzzling. I guess I did not expect a book title that reflects on someone’s achievements to start with ‘no’.  In any case, the book was quite interesting, articulating Peres’s role in some of the policy challenges of the State of Israel.  However, I can never stray too far from my professional interests, and I found that the book included a good many observations relevant to the practice of risk management.

The first observation is that often, not taking a risk is a risk in itself.

So many times in our lives, we struggle to confidently leap forward, averse to the possibility that we will fall flat. Yet this fear of taking risks can be the greatest risk of all.

People in risk and compliance functions should bear this in mind when they advise against a course of action.  However, if you want to take risks or are implementing regulatory risk requirements, you will need to consider meaningful options:  

I’d come to believe that when you have two alternatives, the first thing you must do is look for a third—the one you did not think of, that doesn’t yet exist.

I learned about the virtue of imagination and the power of creative decision making. ... We were quick and creative, and boldly ambitious, and in that we found our reward.

The challenge is really about options being meaningful.  That is not straightforward and requires consistent support from leadership:

“We have to use our imagination and examine any idea, as crazy as it may seem,” I insisted to those assembled. “I want to hear the plans you have.”  “We have no plans,” responded one. “Then I want to hear the plans you don’t have,” I replied.

If leaders demand allegiance without encouraging creativity and outside inspiration, the odds of failure vastly increase. … [W]ithout emboldening people to envisage the unlikely, we increase risk rather than diminish it.

Interestingly, it is Peres’ view that leadership also has an obligation to understand the technical details of the subject matter. 

I felt it essential to gain a degree of mastery in the science that would be driving the project. In previous endeavours, I have come to understand that in addition to a clear vision and strategy, true leadership requires intricate knowledge—a facility with the granular details of every aspect of the mission.

And finally, a word of caution about learning too much from failures:

It is only after we see failure that we can know if we misjudged the risk. ... But one must avoid the temptation to overlearn specific tactical lessons born out of failure or success. … This is one of the hardest things for some leaders to understand: a decision can be right even if it leads to failure.  

This is something that I have covered here. It is not an easy perspective for politicians and business leaders, though I’d like to think that this is where governance might prove itself valuable.

  

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Risk Assurance: The Challenge Ahead

I wrote about risk assurance a while ago (here). More recently, I have had a chance to talk with a few people in banking and consulting about it, and to reflect further on the subject.

By way of background, my working definition of risk assurance is a structured activity undertaken by the risk function (second line) which is aimed at evidencing that risk management is embedded in the business. Feel free to comment on this definition.

The important thing about risk assurance is that it matters because it contributes to shifting (or to maintaining, if you wish) the appropriate risk culture in the business. What do I mean by this? I hope we can all agree that the appropriate risk culture in financial services is one that includes the following:

• the business takes into account risks in decision making and can evidence that, including compliance with regulatory requirements; and
• the risk function provides the parameters for taking into account risk in decision making (risk appetite framework, stress testing, etc) and aggregate risks.

Truly achieving that is a challenging journey that takes time. Many insurers and banks started the risk management journey as a result of regulatory requirements—Solvency 2 or Basel. In practice, this has meant that sometimes risk functions have taken up activities like approvals that belong to business functions. Risk assurance will generate evidence about how risk management operates in practice. It will also help to shift the focus of the risk function—and, in turn, the business—in the appropriate direction.

I have worked with a number of clients to implement programmes of risk assurance. Interestingly, these engagements have turned out to be rather different because they must reflect the starting point for the business. In one case, the risk function was well resourced, and the focus was planning. In another case, the focus was a combination of up-skilling and evidencing through pilot risk reviews that the activity can add value.

Leaving aside the considerations associated with implementation, it is important that there be a shared perspective about the overall aim of risk assurance, i.e. ‘integrated assurance’. This reflects two simple observations:

• internal audit functions already provide assurance about the overall control environment;
• from a Board perspective, assurance is assurance, regardless of which team/line of defence provides it.

In other words, the aim would be to develop a risk-based assurance plan which covers deliverables by 2LOD and 3LOD in such a way that the Board can understand where independent assurance has been provided.

I would be interested to hear your thoughts.

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Artificial Intelligence and Machine Learning in Financial Services: Implications for Credit Risk Management

A recent paper from the Financial Stability Board[1] considers the implications for artificial intelligence (AI) and machine learning in a number of financial services sectors, including credit risk.

The paper includes a useful section on background and definitions, and provides a clear reminder that these tools identify patterns and correlations rather than causality. I suspect that we will need to be reminded of this distinction more and more, as these tools are being used to explore complex relationships. 

When it comes to credit risk scoring, the FSB is clear that AI may help to make lending decisions quicker. However, regulators are not persuaded that AI credit scoring models outperform traditional models – or at least, “it has not been proved”. For example, a recent paper from Moody’s[2] compares the performance of their own credit scoring model for corporates against three machine learning approaches. Moody’s finds that, on average, the accuracy levels of the four models are comparable, and notes that the key to enhancing credit scoring models is data.  

The FSB notes that the deployment of these AI tools would also allow access to credit to people or businesses whose creditworthiness cannot be reliably assessed through traditional credit scoring models. The FSB believes that this would be a positive development for countries with shallow credit markets (emerging markets?), though less positive for countries with deep credit markets (developed markets?). You have been warned…

Regulators are also concerned with the overall auditability of artificial intelligence models used for credit scoring and the wider impact on credit risk governance. There is an important dimension here about how the model is used in business. Is it operating with some human oversight? This is an important issue for business culture as it forces a consideration of who is ultimately in control. I suspect that the distinction between retail and commercial lending in terms of volume of transactions may become important; the volume of retail transactions might make human oversight more challenging. 

Where does that leave the CEO, CFO or CRO of a bank contemplating the use of AI tools? Here are a few suggestions: 

1.  Have a shared view of the expected business outcomes from deploying AI tools.

2.  Keep monitoring credit risk exposures and alignment with risk appetite even more intensively, as the AI tool might have unintended effects.

3.  Focus on the auditability of the AI tool and its impact on credit risk governance.

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[1] Financial Stability Board, “Artificial intelligence and machine learning in financial services. Market developments and financial stability implications”, Nov 2017.

[2] Bacham, D and J. Y. Zhao, “Machine Learning: Challenges Lessons and Opportunities in Credit Risk Modelling”, Moody’s Analytics Risk Perspectives, July 2017.

Brexit - implications for insurers

The European Commission has issued today a note setting out the practical implications for insurers as a result for Brexit.  There are specific impacts for group internal models, branches, intermediaries and reinsurers.  For the full document, follow this link.  

I would be happy to discuss further the implications for your company.

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Five Risk Management Lessons From Pixar

I read an interview in McKinsey Quarterly with Ed Catmull, one of the co-founders of Pixar, about his management approach for keeping the business innovative (here; registration may be required).  I hoped this article would provide an interesting window into a different sector.  When I finished reading the article, I had found something very different instead.  I had learned a number of useful lessons about the design and implementation of risk management:   

1.  That clear business objectives inform risk taking.  Are there clear business objectives?  How do they relate to risk management?

2.  The impossibility of delivering absolute clarity. Is risk management striking a balance between providing clarity and enabling staff at all levels to respond to challenges as they arise?   

3.       The importance of running experiments.  How do/can we experiment with risk management?  Is this about testing risk metrics?  Product features and claims?  Changes to underwriting criteria? 

4.       Articulating business culture to make it less dependent on key individuals and ensure it resonates beyond senior management.  How do we ensure that the ‘tone from the top’ is echoed by middle management?  

5.       The important distinction between assuming and spreading risks and their focus on the former.  How close is the risk management oversight to product development and risk taking? 

So the next time you watch a Pixar movie, remember that there is a fair amount of risk management behind the scenes. 

This post is part of the series "Aspects of Risk Management".  Other articles are available here.  

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‘Nudging’ Meets Enterprise Risk Management?

It is no exaggeration to say that behavioural economics has become mainstream.  With hindsight, this is not really surprising because the assumptions underpinning economic theory have always been regarded as just that: assumptions. 

The key innovation of behavioural economics are the identification of specific circumstances where there are systematic departures from rational decision making and the development of context-specific predictions of behaviour.  Broadly speaking, departures from rational decision making are referred to as ‘biases’ because outcomes are poorer than the optimal outcomes under rational conditions.  These biases may affect preferences, beliefs or decision making.   Box 1 below shows some common types of biases.

Box 1: Sample of Common Types of Biases Affecting Decision Making

Type	Bias	Description	Example of bias in consumer decision making
Preferences	Reference dependence	Assessments are influenced by the reference point for the assessment ― typically the status quo ― or by a fear of losses.  Depending on the context, this can encourage either too much or too little risk taking.	Purchase decisions are driven by alternatives or product features which are irrelevant to the consumer.
Beliefs	Over-extrapolation	Predictions are made on the basis of few observations believed to be representative from which a real pattern or trend is inferred and, as a result, uncertainty is over- or under-estimated.	The quality of financial advice is assessed on the basis of few successful investments even if these could reflect pure luck.
Decision making	Rules of thumbs	Decision making is simplified by adopting specific rules of thumb such as choosing the most familiar and avoiding the most ambiguous.	Products at the top of a list or offered by large companies are selected.

Another innovation of behavioural economics is the notion that it is sometimes possible to address those biases, and thereby enhance outcomes, by making small changes to the environment ― hence the number of books about behavioural economics with the word ‘nudging’ in the title.  I have come across nudging considerations in terms of sales (e.g. how the default option affects customers’ choices) and in terms of public policy (e.g. the introduction of cooling-off periods in financial services). 

One of the key motivating aspects of enterprise risk management is its effectiveness.  This is not just a challenge concerning an outcome at a particular point in time.  The main aspect of the challenge is putting in place a process that drives enhanced effectiveness.  This is an aspect that has not escaped EU supervisors framing risk and capital requirements for banks and insurers in the EU, which require assessments of risk management effectiveness. 

So how could these two meet?  An assessment of risk management effectiveness could seek to identify behavioural biases that affect the management of risk across the business: for example, in terms of underwriting and investments.  Consider again the biases set out in Box 1: which ones could be relevant to risk management?  If we identify the biases that shape risk management, we can also assess their materiality and consider whether there are ways of addressing them through changes in the operating environment.  If you have any thoughts about how these biases, or others, could affect risk management, I would be very interested to hear them.

This post is part of the series "Aspects of Risk Management".  Other articles are available here.  

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Risk Reviews: Not 'a Bridge Too Far'

The role of a Chief Risk Officer (CRO) and her team in the context of a three-lines-of-defence model in financial services can be best described, in my view, as ‘to protect and enable’ (click here for an earlier post on the subject).   Consistent with that, financial services supervisors in the UK and EU refer to the oversight role that the CRO's team provides. 

There are many issues and considerations in embedding effective risk management in financial services businesses.  At one level, oversight requires the CRO’s team to develop the appropriate engagement with the business to provide support, to challenge and to ensure that risk management features ultimately in decision making.  This may result in recommendations for senior management. 

On its own, this is unlikely to be adequate to evidence appropriate and effective oversight for two reasons.  Firstly, the rationale for covering certain business areas or aspects would not be evident.   Secondly, there may be overlaps with the areas reviewed by Internal Audit. 

The answer is not to restrict the engagement between businesses and the CRO’s team.  Instead, the CRO should put in place a programme of risk review which is coordinated with Internal Audit to avoid overlaps or underlaps.

A structured programme of risk reviews requires consideration of the risks to which the business is exposed and their materiality, as well as business cover.  For example, it would not be sensible to cover just one business area, even if that is the main source of risk. 

The key aspect of the development of a programme of risk reviews is identifying a number of potential reviews that map into a grid of risks, materiality and business areas.  The list of reviews is then whittled down in discussions with the CRO and the leadership team to a programme that is consistent with the scale of the business and the maturity of the CRO’s team.

The Board (or a Risk Committee) should review the proposed programme of risk reviews.  Some businesses require a combined submission from Internal Audit and the CRO to identify a complete assurance landscape.  The CRO’s team should then plan the reviews, including setting out terms of reference agreed upon with the business and delivering them throughout the year.  The CRO should also provide regular reports to the Board about the findings of the various reviews and management delivery of recommendations.

Overall, a programme of risk reviews complements Internal Audit’s activities because of the involvement of the CRO’s team on a real time basis in key business processes such as business planning and product development.  Experience suggests that overlaps with Internal Audit can be avoided and that performing these reviews enables the CRO team to get even closer to the business and embed risk management ― ‘to protect and enable’.   

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Feedback Loops and Enterprise Risk Management (ERM)

One should not take things for granted and this also applies to ERM.  In the case of ERM, this would mean identifying feedback mechanisms about the effectiveness of ERM to provide assurance to boards about the value generated.  This should also generate further insights to enhance ERM’s value added.  

This connection between ERM and value has not escaped supervisors.   On a company level, EU directives covering prudential regulation of banks and insurers include requirements that aim to formalise these feedback mechanisms.

While boards and regulators may be interested in the effectiveness of ERM in specific companies, there seems to be less evidence at an industry level.  Wouldn’t it be useful to understand the link between ERM effectiveness and the role and experience of the CRO? How does board oversight contribute to ERM effectiveness? 

These are challenging questions, which are considered in a recent working paper by Cristina Bailey, assistant professor at the University of New Hampshire, using data for publicly traded US insurers.*  There is a fair amount of statistics and econometrics in this paper which would have been covered through peer review.  There are differences between regulatory requirements on the two sides of the Atlantic, which could challenge the ability to infer from US data for Europe.  However, it would seem that ERM effectiveness is driven by the underlying business rather than regulatory requirements and that the lessons should be transferable. 

So what can we learn from this paper?  There are a number of measures of ERM effectiveness and benefits.  The effectiveness of risk management can be gauged by reference to the ratings awarded by S&P for risk management.  There are five possible ratings: very strong, strong, adequate with strong risk control, adequate and weak.  In the paper, ERM is defined as holistic risk management and is associated with the top two S&P ratings.  ERM benefits can be considered by referring to the volatility in stock returns.  ERM benefits can also be inferred using a measure of strategic industry positioning defined as the difference between the return on assets for the insurer and the top quartile.

Normally, it is important to consider the experience that the CRO brings to the role.  A number of experiences are specifically identified: oversight (e.g. prior experience as CEO or COO), financial (e.g. accountancy qualification or prior role as CFO or financial controller), industry (previous employment in the insurance industry) and risk (previous experience as a CRO or a senior risk management position). 

The analysis suggests that the breadth of the CRO’s experience is positively related to ERM effectiveness after controlling for a wide range of relevant factors.  However, this logic does not seem to apply to the expertise of the risk or audit committee.  But before you despair about the value of effective risk governance provided by a board committee, consider the impact on ERM benefits mentioned earlier by reference to volatility or strategic industry positioning.  The breadth of expertise of the committee members turns out to be a significant determinant of the ERM benefits. 

This result is a useful reminder of the difference between outputs (effective ERM) and business outcomes (e.g. risk reduction).  A potential way of pulling together these results is as follows: a CRO with broad expertise can successfully shape the effectiveness of ERM.  However, the wider ERM benefits depend on shaping the overall direction of the company which requires, amongst others, board committee members with a similar breadth of experience to act on the outputs that the CRO leading an effective ERM system would generate.  The above points to the importance of the qualities of CROs. 

Headhunters Hedley May have also published an interesting paper on the role of the CRO – and the risk function – based on discussions with CROs in banking, insurance, investment management and other stakeholders.**  Their analysis seems to support the above hypotheses about the difference between an effective ERM system and delivering business benefits such as lower volatility.  The qualities of a good CRO were found to include relationship building, influence and an ability to synthesise. These would provide the CRO with appropriate credibility in front of the board to go beyond an effective ERM and affect business decisions.

* ‘The Effect of Chief Risk Officer and Risk Committee Expertise on Risk Management', (forthcoming, www.ssrn.com)

** ‘The Post Financial Crisis Chief Risk Officer: The Teenage Years’, 2015

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Out Outsourcing?

Well, not really.  But I am sure you have heard regulatory concerns about the lack of appropriate controls around outsourcing in financial services.  It is therefore not entirely surprising that the UK’s Prudential Regulation Authority (PRA) has recently fined a bank £1.2 million for failures in the controls associated with outsourcing (here).  There are, however, a number of interesting points about this enforcement case that have broader lessons about the supervisory expectations associated with the use of outsourcing in financial services.

1.  The regulatory expectations with respect to outsourcing within a group or to a third party outside the group are the same.  I have heard this before but I was still expecting to see a recognition that there may be a difference.  I could not really find an obvious distinction in the enforcement notice.  This is particularly relevant in financial services where brands are typically a collection of companies, sometimes with a core staff serving a number of companies, in particular with respect to finance (and, in insurance, actuarial).  This also has implications for risk functions which will also need to articulate how their oversight relates to the various companies.

2.  The outsourcing arrangements are documented appropriately in a timely manner. While putting contracts in place within a group is probably understood to be a regulatory expectation, there are two important dimensions that this case highlights.  The first of these is the importance of putting contracts in place at the outset and undertaking due diligence; bear in mind point 1 above.  This also includes signing the contracts!  Secondly, in the case of internal outsourcing involving a control function, it is important that the roles and responsibilities of the various parties are clearly defined.  This can include determining the different roles of people and teams probably sitting near each other.

3.  The legal form of the outsourcing provider does not matter.  A JV form that effectively provides an outsourcing activity should also be treated as outsourcing. 

4.  The consequences of a lack or breakdown of controls matter a great deal.  If the finance function is outsourced within the group, then a breakdown can have severe financial implications (e.g. unauthorised payments) and can include misreporting of the capital and liquidity position to the PRA.

Last but not least, the response when the issue is discovered remains crucial.  In this case, it involved terminating certain outsourcing contracts and putting in place new ones, transferring finance teams to the relevant company and ensuring operational separation of the Bank from the rest of the group.  In addition, the bank commissioned a firm of accountants to review the matter, undertook its own review of all outsourcing contracts and was subject to a skilled persons review by the PRA.  As in other cases, the fine may not have been the largest cost to the bank.

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This post is part of a series of posts on the practical lessons for risk management from enforcement cases.  The posts are all brought together in the page Enforcement Cases of the blog.

Risk Management Lessons From the Co-op Bank's Demise

One of the fallouts from the financial crisis in the UK was the demise of the Co-op Bank as part of the Co-operative movement.  The UK regulators (the PRA and the FCA) investigated the causes of the bank’s demise and issued simultaneous enforcement notices earlier this year (here and here).  The key failures identified by the regulators are summarised in Box 1. 

One of the key points for the press was the regulators decision to waive any financial penalties, reflecting the financial conditions of the Coop Bank.  However, from a risk management perspective, the enforcement notice represents an interesting catalogue of lessons in risk management for both banks and insurers: 

1.  Risks and business strategy go hand in hand.  It is difficult to manage risks effectively in the absence of a clear and comprehensive strategy for key lines of business. 

2.  A ‘cautious’ risk appetite statement is not enough.  Business decisions still must be evidenced as ‘cautious’ in practice even if this happens on a qualitative basis. 

3. The remit of the risk function includes valuations and accounting decisions.  This is particularly relevant in terms of the challenge and governance to (changes to) assumptions associated with discretionary features about valuation e.g. about the timing of redemption of capital instruments.   

4.  Policies are more than documents.   Compliance with policies must be evidenced.  A complex and changing business reality cannot be captured through prescriptive policies.  Certain discretions must be factored into decision making processes.  The risk oversight should cover how those discretions are applied in practice.   

5.   An open and cooperative relationship with the regulators is not just about issues.  It includes updating the supervisor regarding concerns about the position of senior individuals leading to intended changes.

6.  An effective risk culture is an outcome of business decisions about risk.  This was one of the concerns of the regulators.  The regulator’s articulation of an effective risk culture is interesting: ‘A culture in which accepted orthodoxies are challenged, action is taken to address risks on a timely basis and risk and control functions carry real weight is likely to support prudent management.’  In a nutshell, a risk culture is not end in itself but the means to support prudent management.

The enforcement notice mentions other issues regarding the shortcomings of the risk management oversight and internal audit. 

Finally, it is worth noting that the period of time formally considered by the regulators stretches from July 2009 – weeks before the Co-op Bank’s merger with the Britannia Building Society – to December 2013 – when it ceases to be a wholly owned subsidiary of the Co-op Group.   I don’t think the shortcomings just materialised in July 2009. 

This suggests that the perceived connection between responses to the financial crisis and strengthening risk management may not have been as widespread as it might have seemed.  The shortcomings are clearly serious and while they may not be critical when taken individually or addressed within a short period of time, it is the cumulative impact that had the effect of bringing the Co-op bank's demise.    

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This post is part of a series of posts on the practical lessons for risk management from enforcement cases.  The posts are all brought together in the page Enforcement Cases of Crescendo ERM blog.